Commentary: Anchors and allocations – breaking the grip of 60/40

The 60/40 portfolio is discussed like it's a real thing, when in truth it is really a figment in our collective memory. It describes modern asset allocation about as well as "Happy Days" did the 1950s or "Friends" the 1990s. (Great TV shows both — but a bit detached from the real world.)

60/40 has instead become a convenient straw man for highlighting the benefits of other, more sophisticated strategies: "X has higher returns!; Y has a higher Sharpe ratio!; Z delivers better diversification!" All well and good. But before we dismiss it as an artifact, consider that it offers a clear glimpse of the "genetic code" upon which most modern asset allocation is based, and which still exerts a pronounced anchoring effect on investors. Equities dominate given their high long-term return expectations but require diversification given their high volatility. Bonds provide a negatively correlated asset class with modest positive returns, making them an ideal diversifier. Returns, volatilities and correlations balance: Hence, 60/40.

Asset allocation sophisticates may scoff at the simplicity of this model, preferring instead to speak of risk factors, volatility regimes and conditional correlations. And though these latter-day innovations provide a richer and more nuanced picture of portfolio behavior, they are in some sense just old wine in new bottles. If the objective is high long-term returns, then just about any model will zero in on a portfolio with high equity-risk-factor exposure, diversified by duration ... not that different than the basic 60/40.

Entering 2021, the investment landscape looks unfriendly to traditional allocations. Public markets — both bonds and stocks — are trading at historically rich levels, making it far less likely that we will see a repeat of the strong performance of the past decade, or decades. Our 2021 Long-Term Capital Market Assumptions report foresees a return of just 4.2% nominal for a 60/40 portfolio over the next 10 to 15 years, far below historical levels and not far enough for comfort above expected inflation.

Equally alarming is the possibility that bonds no longer deliver effective risk diversification versus equities. This concern is based on both the low level of current yields, which effectively caps bond returns and limits the value of diversification; and, the risk of less consistently negative correlation between stocks and bonds, which raises the prospect of broader losses.

Stocks-diversified-by-bonds is, then, likely to deliver underwhelming returns and higher-than-normal volatility. But this leaves investors facing a difficult set of options. Reducing bond allocations could make sense in a world of low and rising interest rates, but leaves equity risk undiversified. Reducing equity allocations in tandem could restore balance, but what becomes of the remainder? Cash, yielding approximately zero? Perhaps temporarily, but it's very costly to give up return. Private strategies, with higher return potential but also illiquidity? Maybe, but that could impair flexibility.

There may be a better way. The old model starts with the high and low extremes of the return and risk spectrum — stocks on one end and bonds on the other — blending them to achieve a target risk and return somewhere in the middle. In an environment when both ends of this distribution face serious challenges, perhaps it may be better to start in the middle and work outwards.

Assets with risk and return characteristics between bonds and stocks have been labeled, a bit unimaginatively, as "hybrids." Observing a chart of capital market assumptions, there are several that offer meaningfully higher returns than bonds and lower risk than equities. This presents an opportunity to reach target returns directly rather than placing confidence exclusively on broad assumptions about stock-bond correlation and diversification.

What allows these asset classes to deliver attractive risk-adjusted returns? There is no free lunch, but there are more fundamental explanations:

• Equity ownership of high-quality assets. Core real assets like infrastructure, transportation and real estate take an equity position in hard assets that provide very fixed-income-like characteristics: long-term, high-quality contractual cash flows from a counterparty that can be underwritten with confidence and returns primarily from income rather than price appreciation.
• Mid-level capital structure. Mezzanine debt, convertible bonds and preferred equity benefit from a position in the middle reaches of capital structure (in real estate financing and corporate balance sheets, respectively) — delivering higher cash income than senior debt along with downside protection relative to equity.
• Illiquidity and complexity premium in private credit. Private credit strategies deploy capital to borrowers outside of the public markets, frequently in circumstances where traditional lending is unavailable. Transactional complexity is high (including the levels of covenant protection), but financial terms are generally favorable to the lender relative to liquid market sectors.
• Senior exposure in lower quality balance sheets. High yield occupies the top of the capital structure in lower quality credits, with spread compensation that historically exceeds credit losses by a meaningful amount. Coupled with structurally lower duration that creates resilience in a rising-rate environment, high yield may continue to provide attractive risk-adjusted returns.
• Optionality and volatility sales. Hedged equity and option-income strategies combine active equity portfolios with thoughtfully designed option programs to dramatically shift the distribution of outcomes — protecting downside and/or increasing income in exchange for some reduced upside in strong markets.

The anchoring effect of the 60/40 model is profound and has led to the underrepresentation of risk-efficient hybrid strategies and alternatives assets in institutional portfolios. The current environment provides a perfect opportunity to remedy this historical bias.

To be clear, there remains a fundamental role for traditional asset classes. Investors should own bonds, not because they will perform like they have in the past, but because the path of rates is uncertain and the next flight to quality is never known in advance. Likewise, equity should remain a core holding for all return-seeking investors, as history shows that time in the market is more important than timing the market. Capitalism works, after all. But focus should also be on a permanent core of investments across public and private markets targeting return, risk, diversification, income and liquidity in line with long-term objectives.

Asset allocation may be only beginning to catch up to the diversity of the opportunity set. Perpetuating the balancing act between stocks and bonds may be a false choice if portfolios can allocate to other asset classes that line up with long-term investment objectives. Consider this an opportunity: to reach return targets with less tail risk, to deliver more income with less duration risk and to enjoy more effective diversification than stocks and bonds alone can deliver.

Jared B. Gross is managing director and head of institutional portfolio strategy at J.P. Morgan Asset Management. He is based in New York.. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.